With the large gyrations we’ve been witnessing recently in the major stock indexes, there has been a lot of talk in the financial media about “volatility” becoming more a part of the everyday market. Although it pains me to say it, the purveyors of business news, gossip, and opinions are right this time. I guess that just validates the “broken clock” and “blind squirrel” theories.

The stock market has, in fact, been subject to a greater degree of volatility in recent weeks. But how do we measure that volatility, and what are the financial pundits actually referring to?

It’s a metric constructed by the Chicago Board of Options Exchange (CBOE) known as the Volatility Index — or VIX for short. Just what is the VIX, and what information can be gleaned from its readings?

Measuring Stock Market Volatility: What the VIX Measures

Let’s begin by considering what the VIX measures and how it’s constructed. Once you understand that, you will have a better idea of why you’ve been hearing so much talk about this measurement and the implications you can draw from it.

Here is an excerpt from a report on the VIX found on the CBOE website:

“VIX continues to provide a minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days. This volatility is still calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.”

Notice the use of the word “continues” in the first sentence. That’s because the report I just quoted from was prepared in 2003 by the CBOE to introduce a change in the methodology behind the VIX. I’ll get to that in a minute.

The VIX was originally conceived in 1993 to provide traders and investors with an up-to-the-minute gauge of market volatility. The VIX measures the amount of volatility contained — at any moment in time — in option premiums. In its original form, the VIX was constructed by using a weighted average of the implied volatility of the at-the-money and near-the-money options on the S&P 100 index.

Measuring Stock Market Volatility:Measuring the S&P 500 on the VIX

The composition of the VIX was changed in 2003. At that time, the CBOE created a “new” VIX by making two changes to the original version. First, options on the S&P 500 index were substituted for those on the S&P 100. The CBOE decided that the S&P 500 — a widely followed average commonly used by mutual funds as a benchmark to judge their performance results — was more representative of “the market” than the S&P 100.

The second change made by the CBOE was to increase the amount of options used in the calculation of the weighted average. It was thought that by expanding the number of options used to calculate the weighted average, the VIX in its newer form would provide a more accurate representation of the level of implied volatility currently existing among option premiums in the market.

All options used in the VIX calculation are either in the front month — i.e. the nearest month to expiration — or the second month. The reason the CBOE limits options to the two nearest months is because it is their goal for the VIX to estimate the implied volatility of what an at-the-money option on the S&P 500 would contain with 30 days left until expiration.

The VIX is quoted in terms of a number between 0 and 100 — and normally trades at the far lower end of that range. For instance, as of the close of trading on Monday, June 19 the VIX was at 17.83.

That number represents the anticipated percentage movement — both up and down — in the S&P 500 index over the next 30 days. So, for example a VIX reading of 24 would mean that — based upon the implied volatility in the options on the S&P 500 index in the front and the second months — the index is expected to move within a range of 2% (the 24 VIX reading divided by 12 months) over the next 30 days.

Measuring Stock Market Volatility:Making Reasonable Projections

So, why is the VIX important? For one, it provides you with a reasonable projection of the expected range within which the S&P 500 is likely to trade within the next month. To use the current environment as an example, the S&P 500 closed on June 19 at 1240.14. The June 19 closing VIX reading of 17.83 suggests that options traders and investors anticipate that between now and July 19, the S&P 500 is likely to trade roughly within 1.49% range (17.83 divided by 12) of 1240.14 — or between 1221.71 and 1258.57.

Now, that doesn’t mean the S&P 500 will actually trade within that range. Keep in mind that the VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500’s nearest two months’ option premiums.

Therefore, the VIX — and hence the projection of the S&P 500’s trading range for the next month — is being constantly revised. Nevertheless, that projection — as gleaned from the latest VIX reading — is an accurate reflection of the attitude of traders and investors about current market conditions.

And that reflection of traders and investors’ attitudes is the heart of the VIX’s value. When you can correctly gauge market participants’ attitudes — and then use that information to anticipate likely future price action — you have acquired an additional edge in your efforts to make money in stocks.

In my next Technical Tuesday column, I’ll talk about the meaning of specific VIX readings. More importantly, I’ll discuss how you can use that knowledge to your advantage.

Trade well,

Mark Bail

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Here are some other Sleuth articles about Measuring Stock Market Volatility…

Is the Past Prologue? by Mark Bail
“…In the 36-year period from 1970-2005, the S&P 500 finished in the plus column on 27 occasions, or 75% of the time. Now, that’s really no surprise. Despite some tough times for equities in the 1970s and the rocky 2000-2002 period, much of the past 36 years has been bullish…”

So What’s All This Buzz About Volatility?by Mark Bail
“…The answer to those questions depends, to some degree, on what type of trader or investor you are. If you trade actively, it certainly is important to know how volatility is affecting the market and what it means to your approach to trading. And if you’re an options trader, an understanding of volatility is critical …”

Strike Up the Bands by Mark Bail
“…Now, it’s important to remember that Bollinger Bands do not indicate which direction a stock or index is headed…When you add Bollinger Bands to your analysis, you can also make a more astute assessment of the chances of a strong move taking place and the profit potential in that move…”

A Tool for These Volatile Times by Mark Bail
“…If you have been watching the markets closely, you might have noticed some unusual recent trading patterns. The market has been up one day and down the next. Most of the broad-based indices have moved higher — and are in up-trends. But those indices have taken a very unusual road to higher prices…”

Here are some resources about Measuring Stock Market Volatility…

CBOE The VIX as it’s presented on the Chicago Board of Options Exchange website.

Investopedia A definition and historical explanation of the VIX and how it’s been used by investors.

StockCharts Up-to-the-minute VIX charts as well as weekly movements and technical analysis.

Yahoo! Finance A general summary of the VIX, plus headlines and historical prices.